How To Take Tax Free Income from Your LIRP
Troy Sharpe: We’re going to show you how to take income out of your LIRP tax-free, ensure it stays tax-free forever. Also, what you need to know when it comes to your options when withdrawing money from these types of financial tools.
Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), and host of The Retirement Income Show. Just as a recap, the LIRP is a Life Insurance Retirement Plan. These are becoming ever more popular as time goes on because people are looking for a secure place to deposit their money that’s going to earn interest, grow without having to pay taxes and be in a position once you get to retirement, you can take all that growth. You can take the money you’ve put in. You can take all of that as an annual income stream that you’ll never have to pay taxes on.
Very powerful tools here, not only those benefits, but they also provide family protection in the form of a death benefit as you’ll see in just a minute. Also asset protection, all the money that you put inside here, creditors cannot come and get this money. It’s protected from an asset protection standpoint. A lot of benefits, but like any financial tool, it’s not perfect. There are limitations. There are downsides. This series about LIRPs is to help you understand what those are, how to avoid them, how to properly structure them. Today, we’re going to focus on how to take tax-free income out.
As a refresher, if you haven’t watched the other videos in this series, I encourage you, go back to the beginning, watch these from the beginning. They’re in a series for a purpose because they’re going to give you the foundational knowledge so what I go through here makes more sense and you can better apply it to your situation. With these LIRPs, the first thing is we talked about in the first video, the IRS regulates these. We have to put money in over a series of years. This helps it to avoid being what’s called a modified endowment contract. This is the first thing we have to do to make sure the income we’re going to take out is tax-free.
We just have an example here of $25,000 per year, for five years being deposited into the structure. Day one, we make this very first deposit day one, we have a $600,000 death benefit. Now, this is just an example, depending on your age and your gender, the amount of money you put in will determine what your death benefit is. This is all hypothetical, but it’s meant to get the point across as far as how they function, what you need to be aware of and how we’re going to take income out. I also should say that you have dozens and dozens of companies out there that have their own particular nuances when it comes to these types of strategies.
Please take everything I’m going through today in a general sense, but this is what we have to do as far as structuring it over a series of years with our deposits to get a death benefit so the IRS deems it life insurance, so we can retain all those tax-free benefits, asset protection, et cetera. We make deposits over this five-year period in this example. We have a day one starting death benefit of $600,000. For many of these policies out there as well, this can also be used for medical coverage.
Every policy has its own nuances, but if we needed to access the death benefit while we’re living, this is called a living benefit and it can help pay for certain medical expenses with certain policies. Again, working with someone who understands who you are and how the particular policies can offer benefits and have various features really helps you find the correct one for your situation. Here’s the cash value. That’s what CV stands for.
If you remember from the other videos, LIRPs are like buying a home in the sense that when you buy a home, you have to pay interest to the bank for many years before you actually build up your equity. Well, with LIRPs, you have to pay policy expenses because we’re really buying a death benefit here. There are cost of insurance charges. There are some administrative charges, there are expenses inside the policy. This is just a very general example.
When we make our deposit, the insurance company will take their expenses out, but we’re going to be earning interest here as well. Just to keep this simple, I structure this so we see what our cash value is, but don’t forget there are expenses. We are earning interest. It is not going to be a linear progression like I’ve shown here in this example. The goal at the end of the funding period, in this case, five years, the goal is to have a cash value about equal to the contributions or premium payments that we’ve made over the years.
It might be a little bit less. It might be a little bit more, but this is where we’re building the equity in our LIRP. This is a long-term strategy. As a matter of fact, before we start taking income out, I don’t ever recommend a client take tax-free income from these until it’s been in place for at least 10 years, 12, 13, 14, 15 years is even a better strategy because we’re going to build more equity inside the policy here and have more income to take out tax free. That’s the recap.
Now, after the fifth year, you have no more premium payments. It’s fully funded. It’s actually what we call overfunded, but the cash value you have inside, it continues to earn interest. It’s protected from market losses and it’s going to grow. I’ve projected out to year 15, an estimated $300,000 in cash value because once again, once we get this fully funded, after the funding period, we just have a giant pot of money that’s 100% protected from market losses. It’s going to earn interest as time goes on and the expenses are a lot less at this point as well. The expenses come down significantly. It is a long-term strategy.
Now, year 15, in this example, we have a cash value of $300,000. We’re going to start to take policy loans out. There’s actually two different ways. We can take a loan, which is what we’re going to talk about today. Another option you have is what’s called a withdrawal from basis, and that just means we’re taking out every dollar that we’ve put in first. From that point forward, you could take loans.
A bit of a technicality, but there actually is another way to take money out. We can do a withdrawal from basis before we do loans. For the purpose of this example, these tend to work best whenever we do policy loans, and there are two types of loans that we need to be aware of here. Again, every insurance company has some different features when it comes to how these loans work, but they’re basically the same in this general sense.
The whole goal of these policies for most people is to provide family protection with the death benefit and then have the option or the plan to eventually take income out on a tax-free basis. We’ve put all that money in. Now we start to take money out. This is why it’s tax-free because we’re doing policy loans. We’re borrowing from ourself. You do not pay taxes on a loan. If you get a mortgage or if you get a home loan or a credit card loan, that money is borrowed. It’s not income. You don’t pay taxes on it. That’s why this is tax-free income. We do policy loans from our cash value.
Our cash value continues to earn interest. It will be reduced by the amount we take out. The death benefit will also be reduced, but we start to take these loans out. In this example, $20,000 a year for 30 years. Now, there are two ways to earn or two ways to take these loans. One, we can do what’s called a wash loan. A wash loan is we take the policy loan, let’s say $20,000. We pay 0% interest on that. That’s it, it’s a 0% interest loan. How many of us would like to go to the bank and be able to borrow money on a 0% loan? You can do that with most of these policies that are out here in the marketplace.
The second way that does carry a bit of risk, but also a lot of reward is to take a participating loan. What is a participating loan? A participating loan means that all the money that you’ve taken out, it continues to participate in the market growth if there’s growth inside the policy. Let’s look at this, let’s say we’ve taken this first year, $20,000 out. If we choose a participating loan, even though we’ve taken that money and we’ve put it in our pocket, if the policy earns interest, the money that we’ve taken and put in our pocket, it is actually earning interest too. That interest is added to our cash value.
Let’s say we’ve taken $200,000 out and they’re all policy loans of the participating variety. That’s a $200,000 pot of money that we’ve put in our pocket. We’ve spent, we’ve used for whatever it may be but that $200,000 that we’ve taken is still earning interest. That interest gets added into the cash value of your policy, which can help to inflate those values over time and allow you to take more loans, larger loans for a longer period of time. Now, there is a cost for participating loans and every insurance company it’s different. It could be a 4% loan rate, a 6% loan rate, a 5% loan rate.
One of the most important things that we want to see for our clients if they’re going to use a strategy like this as a small part of a much bigger retirement plan is we want to see a cap on what’s called this variable loan rate, because this is a variable loan rate. The insurance company based on interest rates can typically adjust that rate on your policy loans as time goes on. To protect you, the consumer, you need a policy that will cap that variable loan rate, which means they can’t raise it up to 8% or 9% or 10%. We want a cap.
It’s kind of like a mortgage where you have prime plus but it can’t go higher than X. In this example, we want to see somewhere around about a 5% or a 6% variable loan rate because most of these policies have the opportunity to earn much more interest on an annual basis than that variable loan rate cap. We’re trying to have a little bit of what’s called arbitrage here. If we’ve borrowed $200,000 from ourselves at 5% but the policy is earning 7% on average which is very doable, then we’re creating what’s called a 2% arbitrage. We have that money, we’re spending that money, but it’s still earning interest.
These are the two types of loans that we need to be aware of. One of the big risks here, of course, is that if we take too much money out of this policy, if it’s not managed properly one of the things you absolutely have to be aware of is that all of the income that we have taken, that we’ve borrowed from ourselves that’s tax-free over the years if the cash value goes to zero and the policy no longer is in force while you’re alive, then all of that previous year’s income that you’ve taken now becomes subject to income tax. That is one of the risks of doing a participating loan if it’s not managed properly or paid attention to it.
We typically don’t have to worry about that as much with a wash loan, but we do have to run what’s called an in-force illustration. Look at the guarantees, look at the projections and look to see where we are before we make a decision each year with what we’re going to do for our loans. A lot of information here but this was an introduction into how you can take money out, some of the things you need to be aware of, not just the benefits but also the potential risks.
If you are considering a LIRP, if you already own a LIRP, this is a great video for you to continue to learn. Please, share it with a friend share it with a family member, hit that thumbs up button and also subscribe to the channel so you can stay up to date with the content we’re uploading to keep you better connected to your money.
